The desirability of free capital movement is an article of faith for the international organisations that seek to govern the global economy. The perspective is shared by the governments of most developed countries. Liberalisation of capital markets is typically part of the medicine prescribed to ailing countries. A weakened country might consider imposing capital controls in a bid to gain some relief from a battering in the global financial markets, but international treaties can stand in its way. This is part of the challenge currently facing Hungary, as discussed by Frances Coppola here.
A month ago I blogged On the wisdom of free capital markets, in which I drew on James K Galbraith and Keynes to argue that an overwhelming emphasis upon retaining the free movement of capital is mistaken. This becomes even clearer when one looks at the issue from a development perspective. Successful development has not been founded upon free capital markets. Free capital markets have led, historically, in a different direction.
Given this starting point, my eye was drawn to an article by Heather Stewart in yesterday’s Observer entitled Financial crisis could turn the tide against unrestricted capital flows.
The piece draws on a recent report by the Bretton Woods Project which argues that it is time for a new consensus on the regulation of capital flows for the benefit of society. The starting point is that while cross-border capital flows can be beneficial, the countries with the most deregulated regimes suffered worst in the recent financial crisis. Not only that, looking back to the Asian financial crisis of the 1990s it was the countries that controlled their capital account – even in the face of opposition from International Organisations (IOs) – that managed to minimise the damage to their economies most effectively. Conversely, the countries that have recently witnessed considerable growth and development – notably China and India – have retained controls on capital movements, again in the face of pressure from International Organisations to liberalise.
Capital flows into a country in the form of long-term investment that can promote positive development, whereas purely speculative flows can be destabilising. The report argues (p.ii) that:
There is considerable consensus in the economic literature that capital flow surges and stops contribute to financial and banking crises. And these crises are more than just headline grabbing events, but have wide-ranging negative social impacts. The way in which financial flows are managed impacts on wealth distribution, poverty, children’s well being, women’s economic advancement and unemployment. These impacts are not generated only by a crisis, as boom periods can also bring problems of inequality and de-industrialisation. Having a fully liberalised capital account also facilitates tax avoidance and tax evasion.
More specifically it draws on the work of Ilene Grabel, writing in 2000, to identify five types of risk associated with unregulated global capital flows (p10):
- Currency risk under open capital accounts has two dimensions … it refers to a country’s exposure to currency speculation and the risk of currency collapse following investors’ decisions to sell their holdings.
- Flight risk refers to sudden capital outflows from an economy because of panic and investor herding, causing sudden drops in asset values. Episodes of capital flight can become self-fulfilling prophecies in the case of sudden drops in confidence.
- Fragility risk refers to borrowers’ and an economy’s vulnerability to external debt obligations. Often fragility risk is heightened by short-term foreign borrowing being used to finance long term investment. Changes in conditions may make it difficult for the borrowers to continue repayment or for an economy to roll-over debt obligations coming due.
- Contagion risk refers to being effected by financial crises that have their origins in other countries through financial integration. Often this may be cross-border versions of investor herding or panic, as was seen in the Asian financial crisis.
- Sovereignty risk describes the risks that a government will be constrained in its ability to pursue independent social and economic policies as a consequence of capital account liberalisation.
The report goes on to argue that there needs to be greater recognition of the value of capital controls to reduce countries’ exposure to these risks and to render fiscal and monetary policy more effective. Recently it appears that IOs are increasingly willing to recognise that capital controls could help in emergencies. But the Bretton Woods Project is arguing for something more routine.
Some control can be gained over capital flows without violating international treaties, but the report argues that recognising the strong pragmatic case for capital controls means going further. This leads to the argument that when treaties are renegotiated – as, for example, it is likely the Lisbon treaty will be – renegotiation ought to encompass a more benign view of measures to enhance or incentivize long-term investment rather than speculation.
These arguments run up against all sorts of objections from the perspective of conventional understandings of the macroeconomy. From the conventional perspective it has been demonstrated in theory that liberalisation will, pretty much by definition, improve resource allocation. Barriers to free movement are consequently an impediment to efficiency and development. My feeling is that this is one of those situations where the only sensible response can be “it works in practice, but it’s impossible in theory – it must be the theory that’s wrong”. That is hardly an outlandish position to adopt. As Lord Adair Turner observed back in 2009, the financial crisis meant that we faced “a fairly complete train wreck of a predominant theory of economics and finance”.
The challenge is building a consensus around an alternative position were “Finance must serve the ends of society, not society the ends of finance” (p1). If that means less ‘hot’ money sloshing about and financial speculators having less scope to scour the world for opportunities to turn a quick buck then so be it.
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